The 'Flations

The incessant debate of whether the economy is inflating or deflating suffers
from a vocabulary problem. This is as it must be since some (Federal Reserve
Chairman Ben S. Bernanke) discuss deflation as falling prices of stuff while
others concentrate on the debt deflation of an overleveraged economy. The latter
is what matters.

This debate often fails to address the important question of "what does it
matter to me?" What matters most is the changing relationship of prices. For
a worker who pays $3 instead of $2 for eggs, "inflation" is his greatest worry.
If, at the same time, the worker receives a 20% pay cut, there may be many
causes, and it is at least symptomatic of "deflation."

The "inflation" and "deflation" debates (at least, in the major media) are
of limited interest when they take an either/or approach. In fact - back to "what
does it matter to me?" - both conditions are present and moving towards a chaotic
conclusion. This should be expected when the Main Street economy is appended
to a financial economy, which by its nature (and high-frequency trading) is
more unstable than a production economy. Since money-printing is still ascendant,
more violent changes in price relationships are certain.

The Bernanke, Geithner, and Summers economy (that is, the economy of the United
States) is following the historical script to hyperinflation, total war or
social disintegration. In War and Peace, Tolstoy describes the prelude,
those halcyon days in Old Moscow: "in those brightly colored rooms - with the
music, flowers, dances, the Emperor, and tables set for eighty ... The mirrors
on the landing reflected ladies in white, pale-blue and pink dresses, with
diamonds and pearls ... In the first hall were the nobility and gentry in their
uniforms ... In the noblemen's hall was an incessant movement and buzz of voices."

The atmosphere was about to change, as some knew but many chose to ignore: "On
the arrival of the news of Austerlitz, Moscow had been bewildered. At that
time the Russians were so used to victories that on receiving the news of defeat
some would simply not believe it, while others sought some extraordinary explanation
of so strange an event." Chairman Bernanke chose (circa 2004) to believe such
odd-ball theories as "the great moderation" and "the global savings glut," both
extraordinarily inept descriptions of a world about to turn over.

Today, still ignorant of the debt deflation that plagues the deleveraging
economy, Bernanke gabs before senators of a fanciful world, akin to a shell-shocked
survivor raving before the Muscovite cognoscenti of the great Russian victory
at Austerlitz. The beautiful people find this reconstruction most pleasing,
so choose to trust it. (This is also a simplified version of how the most (not best)
educated Americans - who dominate government, the media, think tanks, Wall
Street, universities and wherever else they bray - came to ignore Alan Greenspan's
grave deficiencies and to deify him.)

The best families in Moscow held the most possessions and prestige, so they,
as is true of their current-day American counterparts, were the least likely
to acknowledge Russian weaknesses. Respected Muscovites of title and pedigree
were trusted by many of lower rank, and understandably so. Since princes and
counts had the most to lose if Napoleon invaded Moscow, and, the aristocrats
were privy to insider information from the very top, surely it was wise to
follow their bettors' example.

Alas, those who were surest of their own invincibility were the least prepared
for Napoleon's invasion. Tolstoy wrote of simultaneous inflations and deflations,
vast redistributions of wealth, sometimes accumulated over generations, lost
in a matter of hours: "Prices that day indicated the state of affairs. The
price of weapons, of gold, of carts and horses kept rising, but the value of
paper money and city articles kept falling ... Peasant horses [ed. note: a
humble breed] were fetching five hundred rubles each [ed. note: a life savings]
and furniture, mirrors and bronzes were being given away for nothing."

Not to be neglected are the recriminations. Said the Countess Rostov: "Listen
to me Count, you have managed affairs so that we are getting nothing for the
house.... You said yourself that we have a hundred thousand rubles worth of
things in the house.... Look at the Lopukhins opposite, they cleared out everything
two days ago. That's what other people do. It's only we who are such fools." Live
and learn, Countess. That's what happens when you marry the decaying order.

Currently, inflation is present in the money supply, price of gold, and the
U.S. stock and bond markets. These are old themes here, so will be held in
abeyance to discuss an acute deflationary threat. That is income. It is falling
and prices are rising.

David Rosenberg, economist at Gluskin, Sheff, an investment advisory firm
in Canada, calculates that "private incomes" (non-government jobs and transfers)
in the United States have fallen from $8.7 trillion in the third quarter of
2008 to $8.2 trillion in April 2010. Americans lived beyond their incomes for
years. The main source of overconsumption was consumer credit which fell at
an annualized rate of 3.75% in the second quarter of 2010. This demonstrates
ingenuity on the consumers' part given that "the big six issuers have trimmed
total credit available to their customers by 25 percent, partly by shrinking
credit lines and not renewing expired cards," according to an analyst at Credit
Suisse.

Again, there were other sources of spending for the consumer, such as home
equity withdrawal (HEW). In 2005, homeowners cashed out over $800 billion of
HEW. In the second quarter of 2010, this fell to $8 billion. It was hardly
worth filling out the forms.

The government has plugged some holes such as its army of make-work census
takers. (It cost the government $15 to count each head in 2000 and $25 per
scalp in 2010. This is the Information Age?) President Obama intends to extend
make-work to the far abroad, or, at least he did on June 30, 2010, when he
told an audience in Racine, Wisconsin: "When you look at a place like Afghanistan,
or you look at a place like Iraq, so many of our military personnel are having
to engage in work that really should be civilian. So what I'm trying to say
is, don't put all the burden on the military. Make sure that we've got a civilian
expeditionary force that when we go out into some village somewhere....
let's make sure that we are giving them the support that they need in order
for us to be successful on our mission." [Italics added.] Who said government
workers have no imagination?

Over 40 million Americans used food stamps in May 2010, more than one-eighth
of the population. According to Bill King (The King Report), U.S. government
anti-poverty spending has risen 89% since 2000 - from $342 billion to $647
billion. This includes such programs as Medicaid grants, food assistance, housing
vouchers, and child nutrition programs. Unemployment benefits have been extended
several times in the past two years, to 99 weeks at present. The Labor Department
estimates that 1.4 million workers have been unemployed for at least that amount
of time. Nearly 46% of the country's 14.6 million unemployed have been without
a job for more than six months. Despite the fevered attempts to put money into
hands of Americans, there were more house foreclosures in the second quarter
of 2010 - 269,962 - than ever before. That was a 38% rise from the second quarter
of 2009.

This has the feeling of a dyke about to burst. The government's finger is
forestalling the flood with Federal Reserve mortgage security purchases and
government agencies that now issue over 90% of home mortgages. This does not
put beer on the table which is a reason to think the housing market is going
to topple again.

It is rare for beer sales to decline, yet, as described in the May 28, 2010,
issue of Grant's Interest Rate Observer: "In the 10 years to 2007, American
beer shipments rose by an average of 1% a year. They rose by even less than
1% in 2008 and fell by 2% - a virtual collapse in beer terms - in 2009." (There
has been a drift to wine and spirits, but an attempt to find comparable sales
data was unavailing.) In another land with stagnant incomes, or, at least where
the sun seems to be perpetually setting - Japan - "Spending by Japanese businessmen
on beer and sake is at an eight-year low as tighter household budgets squeeze
their entertainment expenses. Salarymen go out drinking on average 2.9 times
a month, spending about 4,190 yen ($46) each time, a 19% decline from a year
earlier." (Bloomberg, June 10, 2010). Cigarette sales are also falling
in the United States, and, in Europe, cell phone usage dropped 4% in the first
half of 2009. These trends indicate that "necessities" may be defined down
as well as up.

Reduced circumstances will grow more acute as prices continue to rise. The
U.S. government contends prices are not rising. Count Rostov could do a better
job. Almost anyone who pays health insurance premiums (health costs are 16%
of the economy but only 4% of the consumer price index); tuitions (Harvard's
are increasing 4% this year); utilities ("The Los Angeles Department of Water
and Power is planning to boost the electricity bills of its customers by 37%
over the next four years as part of its effort to cover steadily rising costs." - L.A.
Times, March 26, 2010); and cable bills ("Your cable bill is going up this
year -- and next year, and the year after that -- with no end in sight." CNN -
January 9, 2010); and who buy food and gas are falling behind in relation to
the nation's income.

A food study might be most illuminating, but the reader will be spared such
a discourse. It is worth remembering though, that food and energy are not priced
in the United States. Brazil, which is booming, sends this reminder from a
member of our happy Global Village: "Brazil is running out of beer cans and
farmers are leaving crops in the field as surging demand and Chinese-like growth
leads to shortages in Latin America's biggest economy. Cia de Bebidas das Americas,
the region's largest brewer, had to import beer cans for the first time in
its 125-year history after local supplies were exhausted. Acucar Guarani SA,
the country's third-biggest sugar producer by market value, left 10% of its
crop sitting in the fields an extra 40 days because of a shortage of tires
for its harvesters, even after the commodity hit a 29-year high in February." (Bloomberg,
June 8, 2010)

On August 3, 2010, Chairman Ben Bernanke told an audience in Charleston, South
Carolina: "[R]ising demand from households and businesses should help sustain
growth," and consumer spending "seems likely to pick up in coming quarters
from its recent modest pace." Well, consumers will be spending more on sugar,
beer cans, and cell phones (if they still use them) and Simple Ben's money
printing will ensure a chaotic, and impoverished, finish. The Countess Rostov
should mop the floor with him.

Sheehan serves as an advisor to investment firms and endowments. He is the
former Director of Asset Allocation Services at John Hancock Financial Services
where he set investment policy and asset allocation for institutional pension
plans. For more than a decade, Sheehan wrote the monthly "Market Outlook" and
quarterly "Market Review" for John Hancock clients.

Sheehan earned an MBA from Columbia Business School and a BS from the U.S.
Naval Academy. He is a Chartered Financial Analyst.